How often have you heard this? A great thumb rule is to save 20% of your salary towards retirement. And as you get increments every year, the amount saved naturally increases. I believe this is wise and have often recommended it.
I am not so sure of its efficiency now.
Have you ever considered what happens when you get that raise? When your income increases? Your lifestyle goes a notch up. And the next year, again. Over time, what you consume undergoes a perceptible shift as your income rises. Where you eat. How often you order takeaway. Where you shop. The kind of brands you buy. The car you drive. The phone you use. The visits to the spa.
As US-based financial planning expert Michael Kitces explained once: I used to mow the lawn, but now I got a little more money. So, I'm going to pay someone to mow my lawn. Once I pay someone to mow my lawn, I rarely go back to mowing the lawn again. Once we get used to a certain standard of living, it is traumatic to move backward.
Every single habit or pattern compounds. Saving consistently compounds. So does spending. Your standard of living starts to rise. This is going to cost you more in the future once inflation is accounted for. Which means that you need to be saving much more to keep up with that.
Let's revisit the Thumb Rule: You save 20% of your salary.
When it was Rs 12 lakh per annum, you saved Rs 2.40 lakh. Over time it doubled to Rs 24 lakh per annum, causing you to save Rs 4.80 lakh. The 20% has stayed consistent, and the absolute amount has increased. But this also means that a huge chunk of your salary is now supporting a lifestyle that you could not afford earlier.
Kitces brutally nails it: “It basically says, I'm going to keep saving 20% of my income and spend 80% of every raise.”
When you look at it from that lens, it is not at all comfortable.
This is commonly known as Lifestyle Creep.
As your discretionary income rises, so does your standard of living. This is not something that happens overnight, it creeps up on you over the years, which makes it all the more dangerous. Because you really don’t see it inching up, it is not a budget breaker. But it starts piling up without you being consciously aware, which then leads inexorably to higher living expenses.
Lifestyle Creep has severe ramifications:
- You need much more money in order to retire because your lifestyle has gotten upgraded.
- But, you have been saving less because your spending is increasing along with the rise in your income.
- Your lifestyle cost has increased at a much faster rate than your savings.
- After getting a raise, you have adopted a higher standard of living that you will need to to match in retirement, but you are not committing the necessary funds to reach this new goal.
So what must you do?
Morningstar looked at some guidelines to determine how much of a 5% raise a person should save to ensure his retirement income continues that lifestyle change. This was based on the data of the U.S. 2016 Survey of Consumer Finances.
- Spend twice your years to retirement. If you are going to retire in 10 years, spend 20% of your raise and save the remaining 80%. If you are going to retire in 15 years, spend 30% of your raise and save the remaining 70% for retirement. This requires the most saving and may be difficult for those with little discretionary income.
- Save your age, as a percentage of the raise. If you are 50 years old, save 50% of the raise.
- Save at least 33% of your raise. If your take-home income increased by Rs 1,000, you should save Rs 333 of that new income.
The latter two are good for investors under 45, but they fall short as the person ages. As you get older, please save as aggressively as possible. Closer to retirement, you have less time to accumulate savings and less time in the market to generate returns.
Use the above as guidelines and be flexible with your situation.
This is important
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- Be happy.
Look forward to every raise, because you're going to spend more, and because you earned it. Just don't spend all of it. This implicitly increases your savings.
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- Be aware.
Pay attention to your standard of living and try to exercise some restraint. You don’t have to eliminate, but cut down. If you work in a café thrice a week and spend on coffee and “something to munch on”, reduce it to twice a week.
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- The two feed on each other.
By exercising some control on lifestyle creep, your savings increase. And, you will not need as much for retirement as you would if you were very liberal in upgrading your standard of living.
Don’t get stuck in a raise.
Don’t ignore your future self.
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Larissa Fernand is an Investment Specialist and Senior Editor for Morningstar India. You can follow her on Twitter.
